Regulatory Compliance in the Automobile Industry

This paper analyzes compliance with emission regulations, focusing on investment in innovation and cheating as primary strategies. Firms prioritize developing a truly compliant technology but may activate a cheating device depending on the outcome of innovation, the monitoring system in place, and the size of compliance costs. Successful innovation achieves compliance at lower costs, while undetected cheating creates the appearance of compliance while eliminating all compliance costs. Relying on the automobile sector as a case study, we explore the path-dependent nature of cheating and investment decisions and demonstrate that investment in innovation and cheating are strategic substitutes. Firms invest less in innovation when they anticipate using a cheating device, either systematically or as a fallback when innovation fails. We derive policy recommendations from comparative statics based on compliance costs, enforcement efforts, and competition. Finally, we assess whether the increased ease of cheating benefits the automobile industry and show that firms may continue to rely on this strategy even when it is inefficient.